Making Things Worse


Markets continued Monday’s late strength on the renewed optimism about Dexia being saved or broken up cleanly, on the talk that the IMF would be contributing to the rescue of European banks, and on the hope that a coordinated rescue was in the works. The rally continued despite the fact that the latest plan has Dexia being stripped of the good assets and just left as a bad bank without any capital injections, that the director of the IMF’s European Department said ‘we are not contemplating any market involvement with the EFSF’, and that German Chancellor Angela Merkel said the European rescue fund not only wasn’t being used for a coordinated rescue, but that it was “only a last resort” for banks.

The fact that the market continued higher despite the complete dashing of the hopes that had driven it higher in the last minutes of Monday’s session surely means that the market is no longer trading on hopes; it’s trading on dreams. We must remember that what the most-optimistic dreamers are wishing for is for a large, multinational coalition of politicians to come up with a workable plan to save a mess decades in the making. There is no shame in betting that politicians will be unable to discover a workable plan even if one is staring them in the face – and the fact that if there is any salvation left it must be seen through a very narrow window indeed makes it highly unlikely in my view that help is on the way in a useful sense.

As if to drive home this point, Europe’s space agency announced that it is sending a spaceship on a scientific mission to the sun. Asked about the technical complexities of conducting a mission in the thousand-degree heat near the sun, Sarkozy declared “but we have solved this problem. We are going at night.”[1]

Interest rates rose today, and commodities rallied along with inflation swaps. The better-than-expected print from ADP (91k versus 75k expectations) provided some following wind to these moves. It was definitely as encouraging as a sub-100k number might be, considering the growth fears that loomed all-too-recently.

I am all for being optimistic about the possible outcomes, but I insist on being realistic and thinking about what might actually cause things to improve. To be sure, animal spirits in the economy can spontaneously reverse but I see no reason why they should at the moment. Moreover, policymakers keep looking for ways to make things worse. The U.S. Congress is considering a punitive move against China. Some lawmakers are proposing a surtax on millionaires. The Fed is working very hard to completely obliterate the funding status of pension plans by pushing yields ever lower at the long end – which at this point can be fairly obviously seen to be impotent in terms of provoking mortgage refinancing so only the bad parts of lower rates remain.

And while I’m on the subject of Operation Twist, let me point out a sinister side effect of it. When the Fed did QE1 and QE2, they noted in various speeches that the balance sheet expansion could be unwound directly (by selling the bonds back into the market) but also could return to normal naturally as the Fed allowed maturing bonds to simply roll out of the portfolio without being reinvested. By selling the short bonds and replacing them with longer bonds, the Fed is eliminating the ‘natural contraction of the balance sheet’ option. The balance sheet will now have very few bonds primed to mature in the next few years.

This means that if the Fed decides it wants to permanently shrink the balance sheet (to soak up some of the excess reserves, for example if inflation began to accelerate) it will have no choice but to sell bonds into the market to do so. Now, SOMA chief Brian Sack has made it clear that he believes buying bonds lowers rates but selling them does not – but those of us with market experience beg to differ. When the Fed was buying trillions, it had a ready seller in the Treasury. But when it goes to sell those bonds, it will be competing with the Treasury.

If the Fed needs to sell $1 trillion of bonds at the same time the Treasury is raising $1 trillion in new money, we have an unprecedented supply of bonds on our hands. It is akin to the ‘mortgage extension’ waves that have periodically shoved rates violently higher when mortgage portfolios get naturally longer in a bond market selloff (forcing those portfolio managers to sell bonds into the selloff). But it is much, much larger in magnitude, and it comes at a time when the Street has been told not to take proprietary risks – which in a normal selloff, it does in order to ‘temporally distinermediate.’[2]

Prior to Twist, the best chance that we wouldn’t have to confront a sharp bond market selloff at some point was that the portfolio might be slowly unwound through maturity of its holdings. This will no longer be possible. Moreover, the timing of the Feds’ exit isn’t entirely in their hands. Right now there are massive reserves which have been passing into transactional money only slowly. The money multiplier remains depressed, although it is rising again slowly now that the Fed is no longer adding reserves via QE2 (see Chart). If it starts to rise again, the Fed will need to withdraw the reserves fairly rapidly or face a serious inflation issue and/or a potential dollar crash.

M2 divided by the adjusted monetary base. The effect of QE is clearly visible, but when QE stops the multiplier has tended to rise...

If the money multiplier rebounds in an expansion, as banks feel more confident and start to lend more aggressively, then rates will likely already be rising and the Fed will be forced to unload bonds into rising rates. This means that rates will correct in such a case much further than they otherwise would. This is not a trading recommendation: I have no idea when this will happen. But if it happened, then instead of letting long rates adjust gradually to 4-5%, they might suddenly be shooting to 7% or higher.

The second possibility is that the money multiplier might naturally revert to its ‘normal’ level through some other mechanism. Remember, we’ve never done this so we’re really not sure, whatever they tell you, that it will work the way the textbooks say it should. Nothing so far has, anyway! If the money multiplier starts to revert naturally somehow, then the Fed really faces a nasty situation in which it will have to decide whether to let the money supply explode or aggressively sop up liquidity and drive interest rates higher in the process.

This has always been the dilemma following QE1 and QE2, but as I said there was always the possibility that the exposures might just roll off naturally, or at least enough of them would that sopping up the extra liquidity would be less problematic.

But now, like all policymakers everywhere seem to keep doing, the Fed has made things worse.


[1] The Sarkozy response is fictional, but ask yourself whether you didn’t have just a moment of doubt about that.

[2] This is a fancy term that means a dealer buys when the seller shows up, then sells when the buyer eventually shows up. If there is no dealer to do this, then if a seller needs to sell he can only sell to the buyers present at that moment. When there are no dealers to temporally disintermediate, you get flash crashes.

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  1. Frank R.
    October 6, 2011 at 7:28 am

    I have been associated with the space program for 40+ years. The fictional Sarkozy response is just one variant of a very old joke. But you’re right: considering the source…hmmm?

    There have been proposals for (spacecraft suicide) missions to the sun to measure the near-sun environment as closely as possible. The current Messenger mission (orbiting Mercury) is the closest we have come and the spacecraft seems to be surviving quite well at that distance. Lots of on-board thermal protection and dissipation technology.

    BTW: Welcome back 🙂

  2. Lee
    October 6, 2011 at 3:30 pm

    If the Fed and the Treasury are both selling, I don’t understand why that wouldn’t raise rates. (And I didn’t have a moment of doubt.)

  3. October 6, 2011 at 9:34 pm

    Thanks. I actually know the joke as an old Aggie joke. I just couldn’t resist, when I saw it. 🙂

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